Donate to Remove ads

Got a credit card? use our Credit Card & Finance Calculators

Thanks to johnstevens77,Bhoddhisatva,scotia,Anonymous,Cornytiv34, for Donating to support the site

Balance sheet question - Derivative financial instruments

Analysing companies' finances and value from their financial statements using ratios and formulae
TheMotorcycleBoy
Lemon Quarter
Posts: 3245
Joined: March 7th, 2018, 8:14 pm
Has thanked: 2222 times
Been thanked: 587 times

Balance sheet question - Derivative financial instruments

#154062

Postby TheMotorcycleBoy » July 22nd, 2018, 8:16 am

Morning,

I'm looking at TATEs reports, and also musing about processing/analysing company financials in general.

So on pg102 of

https://www.tateandlyle.com/sites/defau ... 0FINAL.pdf

we have entries for both CL and NCL described as being "Derivative financial instruments". I went to the related Note 28 and although a couple of the constituents of this entry have "interest" in their name e.g. "interest rate swaps", since there is no mention of a specific rate associated, i.e. in the words following the table in Note 28; would I be correct to assume that these things (DFIs), in general, have no associated annual interest charge applied to them, and hence should not be classed as debt?

many thanks
Matt (and Mel)

Alaric
Lemon Half
Posts: 6035
Joined: November 5th, 2016, 9:05 am
Has thanked: 20 times
Been thanked: 1400 times

Re: Balance sheet question - Derivative financial instruments

#154074

Postby Alaric » July 22nd, 2018, 9:38 am

Melanie wrote:would I be correct to assume that these things (DFIs), in general, have no associated annual interest charge applied to them, and hence should not be classed as debt?


Derivative Financial Instruments can be used by Companies to manage their borrowings, one of the uses being to cap the amount they have to pay in interest. They probably are equivalent to debt therefore.

TheMotorcycleBoy
Lemon Quarter
Posts: 3245
Joined: March 7th, 2018, 8:14 pm
Has thanked: 2222 times
Been thanked: 587 times

Re: Balance sheet question - Derivative financial instruments

#154075

Postby TheMotorcycleBoy » July 22nd, 2018, 9:48 am

Alaric wrote:
Melanie wrote:would I be correct to assume that these things (DFIs), in general, have no associated annual interest charge applied to them, and hence should not be classed as debt?


Derivative Financial Instruments can be used by Companies to manage their borrowings, one of the uses being to cap the amount they have to pay in interest. They probably are equivalent to debt therefore.

Why is that?

From a naive viewpoint if they don't attract a direct interest charge, then how is this debt? Certainly no such charge/rate is mentioned in Note 28. (in the case of TATE 2018). Surely were I to extend this thought process then I could describe any line in a liability as debt, whereas I am lead to believe that in calculations of debt measures, this is not usually the case, and it is only the interest bearing items that are included.


The ineffectiveness recognised in profit or loss in the current period arising from net investment hedges was £1 million gain (2017 – £nil).
The ineffectiveness recognised in profit or loss in the current and prior periods arising from fair value and cash flow hedges was not material.
Cash flow hedges
The Group employs commodity pricing contracts to hedge cash flow risk associated with forecast transactions. Gains and losses
recognised in the hedging reserve in equity (see Note 23) on commodity pricing contracts at 31 March 2018 are expected to be reclassified
to the income statement at various future dates.
Fair value hedges
The Group employs interest rate swap contracts to hedge interest rate risks associated with its borrowings. The notional principal
amounts of the outstanding interest rate swap contracts applied in fair value hedging relationships as of 31 March 2018 were
£150 million (2017 – £150 million).
Net investment hedges
The Group employs currency swap contracts to hedge the currency risk associated with its net investments in subsidiaries located
primarily in the US and Europe. The notional principal amounts of the outstanding currency swap contracts applied in net investment
hedging relationships as of 31 March 2018 were £169 million (2017 – £182 million). Within net investment hedging gains/losses, a fair value
gain of £14 million (2017 – £21 million loss) on translation of the currency swap contracts to pounds sterling at the period-end date was
recognised in the currency translation reserve in shareholders’ equity (see Note 23).
In addition, at 31 March 2018, of the Group’s liabilities, a total of £163 million (2017 – £188 million) are designated as hedges of the net
investments in foreign operations.


Maybe.....does the firm that they acquired the DFI from expect the thing back (i.e. monies) at any time soon?

Matt

Alaric
Lemon Half
Posts: 6035
Joined: November 5th, 2016, 9:05 am
Has thanked: 20 times
Been thanked: 1400 times

Re: Balance sheet question - Derivative financial instruments

#154094

Postby Alaric » July 22nd, 2018, 12:05 pm

Melanie wrote:Maybe.....does the firm that they acquired the DFI from expect the thing back (i.e. monies) at any time soon?


The term DFI is a collective noun for contracts described as Cash flow hedges, Fair value hedges and Net investment hedges.

TheMotorcycleBoy
Lemon Quarter
Posts: 3245
Joined: March 7th, 2018, 8:14 pm
Has thanked: 2222 times
Been thanked: 587 times

Re: Balance sheet question - Derivative financial instruments

#154096

Postby TheMotorcycleBoy » July 22nd, 2018, 12:09 pm

Alaric wrote:
Melanie wrote:Maybe.....does the firm that they acquired the DFI from expect the thing back (i.e. monies) at any time soon?


The term DFI is a collective noun for contracts described as Cash flow hedges, Fair value hedges and Net investment hedges.

Ok, but that doesn't answer the question(s) by posed in:

viewtopic.php?p=154075#p154075

mc2fool
Lemon Half
Posts: 7812
Joined: November 4th, 2016, 11:24 am
Has thanked: 7 times
Been thanked: 3017 times

Re: Balance sheet question - Derivative financial instruments

#154102

Postby mc2fool » July 22nd, 2018, 12:20 pm

Melanie wrote:...we have entries for both CL and NCL described as being "Derivative financial instruments". I went to the related Note 28 and although a couple of the constituents of this entry have "interest" in their name e.g. "interest rate swaps", since there is no mention of a specific rate associated, i.e. in the words following the table in Note 28; would I be correct to assume that these things (DFIs), in general, have no associated annual interest charge applied to them, and hence should not be classed as debt?

Ok, firstly, interest rate swaps these aren't a debt but a contract to exchange interest payments on a debt in order (in the way companies usually use them) to manage cash flows. E.g. let's suppose you have a variable rate mortgage at currently, say, 5%. You can pay that ok and maybe a little more but, while you have no idea which way interest rates will go, you are concerned that if it goes up much more than 5% you'll be in trouble. You'd prefer the known quantity of a fixed rate, so you enter into an interest rate swap with someone who you pay a fixed 5.5% and they will pay your mortgage interest, no matter how much rates change. Obviously if rates go up to more than 5.5% you're laughing and they've made a poor bet, and vice versa if rates drop, but your goal was not to bet but to to have the peace of mind and ability to manage your cash flows from having the known quantity of a fixed rate. A more formal explanation here: https://www.investopedia.com/terms/i/in ... teswap.asp

Now, on how it's accounted, there are Derivative Financial Instruments listed under both assets and liabilities on p102 and actually the interest rate swaps in Note 28 are listed as assets (your mortgage itself is the debt, not the interest rate swap).

From a naive viewpoint if they don't attract a direct interest charge, then how is this debt?

Things don't have to have an interest charge to be a debt (liability), anything that you owe is.

TheMotorcycleBoy
Lemon Quarter
Posts: 3245
Joined: March 7th, 2018, 8:14 pm
Has thanked: 2222 times
Been thanked: 587 times

Re: Balance sheet question - Derivative financial instruments

#154112

Postby TheMotorcycleBoy » July 22nd, 2018, 12:40 pm

mc2fool wrote:Ok, firstly, interest rate swaps these aren't a debt but a contract to exchange interest payments on a debt in order (in the way companies usually use them) to manage cash flows.

Yes that was exactly what I originally thought.

(BTW, I'm pretty clear on the concept of swaps - but thanks for the link)

mc2fool wrote:Things don't have to have an interest charge to be a debt (liability), anything that you owe is.

Conceptually, yes. However, now that I find myself analysing companies, I discover debt-based ratios, and I'm led to understand (and actually quite believe) that for the purpose of calculated many of these ratios; and indeed appreciate which of an entities liabilities are of most concern, are those upon which an interest charge is levied.

See what you think of this earlier post, another LF wrote, helping me on a related matter:

viewtopic.php?p=143344#p143344

Matt

mc2fool
Lemon Half
Posts: 7812
Joined: November 4th, 2016, 11:24 am
Has thanked: 7 times
Been thanked: 3017 times

Re: Balance sheet question - Derivative financial instruments

#154121

Postby mc2fool » July 22nd, 2018, 1:00 pm

Melanie wrote:
mc2fool wrote:Things don't have to have an interest charge to be a debt (liability), anything that you owe is.

Conceptually, yes. However, now that I find myself analysing companies, I discover debt-based ratios, and I'm led to understand (and actually quite believe) that for the purpose of calculated many of these ratios; and indeed appreciate which of an entities liabilities are of most concern, are those upon which an interest charge is levied.

You can take that view, and it's not an unreasonable one*, but you started off by saying the DFIs shouldn't be classed as debt and (at least on my brief reading of those two pages in the report) I don't see that they are, "debt" isn't mentioned on those pages, they're just classed under liabilities and under assets (and the two balance each other out, give or take a million).

* Although I would point out that while "trade payables" by that definition is a liability that isn't "debt", it was trade payables that landed Tesco in deep doo-doos a few years back and was of definitely of high concern :D

TheMotorcycleBoy
Lemon Quarter
Posts: 3245
Joined: March 7th, 2018, 8:14 pm
Has thanked: 2222 times
Been thanked: 587 times

Re: Balance sheet question - Derivative financial instruments

#154130

Postby TheMotorcycleBoy » July 22nd, 2018, 1:45 pm

mc2fool wrote:
Melanie wrote:
mc2fool wrote:Things don't have to have an interest charge to be a debt (liability), anything that you owe is.

Conceptually, yes. However, now that I find myself analysing companies, I discover debt-based ratios, and I'm led to understand (and actually quite believe) that for the purpose of calculated many of these ratios; and indeed appreciate which of an entities liabilities are of most concern, are those upon which an interest charge is levied.

You can take that view, and it's not an unreasonable one*, but you started off by saying the DFIs shouldn't be classed as debt and (at least on my brief reading of those two pages in the report) I don't see that they are, "debt" isn't mentioned on those pages, they're just classed under liabilities and under assets (and the two balance each other out, give or take a million).

* Although I would point out that while "trade payables" by that definition is a liability that isn't "debt", it was trade payables that landed Tesco in deep doo-doos a few years back and was of definitely of high concern :D


Sorry mcfool,

I think we are both in agreement! I just started this topic, for confirmation/reassurance of my belief.

The only reason why I continued and posted further

was another LF wrote,

viewtopic.php?p=154074#p154074

which seemed to be counter to my understanding.

(and yeah, I agree with your tesco point - indeed debt can be hidden! creative accountancy etc. etc.)

Matt

snagga
Posts: 27
Joined: November 12th, 2016, 10:29 am
Has thanked: 52 times
Been thanked: 24 times

Re: Balance sheet question - Derivative financial instruments

#154251

Postby snagga » July 23rd, 2018, 12:32 am

Melanie wrote:Morning,

I'm looking at TATEs reports, and also musing about processing/analysing company financials in general.

So on pg102 of

https://www.tateandlyle.com/sites/defau ... 0FINAL.pdf

we have entries for both CL and NCL described as being "Derivative financial instruments". I went to the related Note 28 and although a couple of the constituents of this entry have "interest" in their name e.g. "interest rate swaps", since there is no mention of a specific rate associated, i.e. in the words following the table in Note 28; would I be correct to assume that these things (DFIs), in general, have no associated annual interest charge applied to them, and hence should not be classed as debt?

many thanks
Matt (and Mel)


I think I would disagree on both points because:
- many derivatives do have an associated annual interest charge; and
- even if they didn't, I don't see why that means "hence [they] should not be classed as debt."

The major derivatives disclosed are commodity derivatives, interest rate swaps and currency swaps. I didn't see a lot of detail as to what Tate's commodity derivatives are but they probably don't have an explicit interest element. Tate's use of interest rate swaps seems to be the opposite of the example mc2fool describes in that they have fixed rate debt and use the IR swaps to achieve an overall floating rate on a portion of that debt (ie. debt pays fixed rate, swap receives fixed rate and pays floating rate). The difference between the fixed rate and the floating rate on these swaps that accrues each period should be included in the interest expense in the P&L even if Tate has not broken it out. Currency swaps also often include swapping an interest rate in one currency for a different interest rate in another currency. If they are used to hedge foreign currency debt, then the difference between the rates will flow through to P&L. If they are used to hedge net investments, then (looking at Tate's disclosures) I would imagine that it ends up going to the currency translation reserve.

As mc2fool mentions, any liability of a company can be described as a debt. What subset of liabilities should be considered "debt" in a more narrow sense and distinct from other liabilities that are not considered "debt" seems to be a highly judgemental matter. I guess different people will pick up different numbers to calculate different ratios. I suppose it depends what the purpose of the ratio is. Many will think it important that derivatives are usually entered into with financial institutions, not customers or suppliers, and contain detailed terms and conditions as to default, collateral, termination, etc. Tate provides disclosures about what it considers to be "net debt" in note 27. In an economic sense all liabilities that involve providing credit over a long period involve some element of financing return even if the interest element is not explicit - and in most cases liabilities are measured in the balance sheet at a present value and an interest expense is imputed to get to the nominal amount finally payable on settlement if it is materially different. With respect to Tate's IR swaps, IMHO it would be odd to exclude them from "debt" given that they are hedging debt. As noted above, there is an interest expense on them. The fair value hedge accounting that Tate describes also means that offsetting fair-value adjustments arise on the carrying amounts of the debt ant the swaps each period (eg. if interest rates go up, the debt liability might be reduced by £Xm and the liability for the swaps increased by £Xm).


Return to “Company Analysis”

Who is online

Users browsing this forum: No registered users and 5 guests